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Treatment of Foreign Currency Option Gains

By Andrew Gantman, CPA, Woodland Hills, CA

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Tax Section

Editor: Mark G. Cook, CPA, MBA

As
many practitioners know, Sec. 988 treats most (but not all)
gains and losses from foreign currency transactions as ordinary
in character. Depending on the taxpayer’s circumstances, this
treatment can be favorable or otherwise.

While the full
range of exceptions to this rule is beyond the scope of this
item, there is one that may be of particular interest to
investors.

Example: Individual U.S. investor
K holds substantial foreign stocks (on the London Stock
Exchange) denominated in foreign currency. K is
concerned about possible fluctuations in the U.S. dollar/U.K.
pound exchange rate and decides to manage that risk by
purchasing a foreign currency option directly from a U.S.
investment bank (see the exhibit on p. 741).

In this example, K pays $15,000 for the right to
receive (in cash) the net value of the excess of the U.S. dollar
(USD) amount over the U.K. pound (GBP) amount on the valuation
date. If there is no net positive excess, no additional money
changes hands.

More specifically, if on the valuation
date the spot exchange rate is 1.6 USD/GBP (i.e., the value of
the USD has increased compared with the GBP), K would be
entitled to receive $650,000 – (£345,000 × 1.6 USD/GBP) =
$98,000. After consideration of the option premium, K’s
net profit would be $83,000.

Query:Should this profit be characterized
as ordinary income or capital gain? If the latter, what is the
holding period? While the answer might seem clear at the outset,
getting there is somewhat circuitous and may also require
specific action on K’s part in the form of an election
by the end of the trade date.

Sec. 988

In
general, Sec. 988 treats foreign currency gains and losses
attributable to a Sec. 988 transaction as ordinary income or
loss. Moreover, by its express terms, Sec. 988 overrides any
other contrary provisions under chapter 1 of the Internal
Revenue Code (Secs. 1–1400U-3, dealing with normal taxes and
surtaxes). However, exceptions do apply.

In determining
whether a particular arrangement is covered by this rule, Sec.
988(c)(1) treats as a Sec. 988 transaction any specified
transaction (e.g., any forward contract, futures contract,
option, or similar financial instrument) if the amount the
taxpayer is entitled to receive (or is required to pay) by
reason of the transaction is determined by reference to the
value of one or more nonfunctional currencies. Because the
option in this example meets those criteria, it would appear (so
far) to constitute a Sec. 988 transaction and presumably give
rise to ordinary income.

Interplay with Sec. 1256

Next, consider Sec. 988(c)(1)(D), which provides that the
acquisition of any forward contract, futures contract, option,
or similar financial instrument is not a Sec. 988 transaction if
it represents a regulated futures contract or nonequity option
that would be marked to market under Sec. 1256 if held on the
last day of the tax year.

Under Sec. 1256(g)(1), a
regulated futures contract is a contract for which the amount
required to be deposited and the amount that may be withdrawn
depend on a system of marking to market and that is traded on or
subject to the rules of a qualified board or exchange. In the
above example, the option is clearly not a regulated futures
contract because no amounts were required to be deposited or
able to be withdrawn.

Under Sec. 1256(g)(3), a nonequity
option includes any listed option that is not an equity option.
Sec. 1256(g)(5), in turn, provides that a listed option is one
that is traded on (or subject to the rules of) a qualified board
or exchange. Sec. 1256(g)(7) further provides that the term
“qualified board or exchange” means (1) an SEC-registered
national securities exchange; (2) a domestic board of trade
designated as a contract market by the Commodity Futures Trading
Commission; or (3) any other exchange, board of trade, or other
market that Treasury determines has rules adequate to carry out
the purposes of Sec. 1256.

While this statutory language
is less definitive than some might like, the IRS has provided
guidance in identifying certain entities as qualified boards of
exchange for purposes of Sec. 1256. Nevertheless, in the
example, the foreign currency option was not traded on (or
subject to the rules of) an exchange of any sort. Consequently,
the option should not constitute a nonequity option.

As
a result, the option should not be excluded from consideration
as a Sec. 988 transaction by Sec. 988(c)(1)(D). It would
continue to appear (so far) to constitute a Sec. 988 transaction
and presumably give rise to ordinary income/loss.

Election to Treat as Capital Gain/ Loss

Having
established the option as a Sec. 988 transaction, one of the
exceptions to ordinary income/loss treatment is found in Sec.
988(a)(1)(B), which permits taxpayers to elect to treat
gains/losses on certain foreign currency arrangements as capital
in nature. This exception provides that (unless prohibited in
the regulations), among other things, a taxpayer may elect to
treat any foreign currency gain or loss attributable to an
option that is a capital asset in the hands of the taxpayer and
that is not a part of a straddle as capital gain or loss if the
taxpayer makes an election and identifies the transaction before
the close of the day on which such transaction is entered into
(or earlier, as Treasury may prescribe).

Capital asset characterization:In relevant
part, Sec. 1221(a) provides the definition of a capital asset as
property held by a taxpayer, but it excludes:

Any commodities derivative financial instrument held by a
commodities derivatives dealer; and

Any hedging
transaction that is clearly identified as such before the
close of the day on which it was entered into (or such other
time as Treasury may by regulations prescribe).

With respect to the first item, the investor is not a “commodities
derivatives dealer” because he or she is not a person that
regularly offers to enter into, assume, offset, assign, or
terminate positions in commodities derivative financial
instruments with customers in the ordinary course of a trade or
business (Sec. 1221(b)(1)(A)).

As for the second item, the
option is not a hedging transaction because it was not a
transaction entered into by the taxpayer in the normal course of
the taxpayer’s trade or business primarily:

To
manage risk of price changes or currency fluctuations with
respect to ordinary property that is held or to be held by the
taxpayer;

To manage risk of interest rate or
price changes or currency fluctuations with respect to
borrowings made or to be made, or ordinary obligations
incurred or to be incurred, by the taxpayer; or

To manage such other risks as Treasury may prescribe in
regulations (Sec. 1221(b)(2)).

Accordingly,
because the option does not meet any of the exceptions in Sec.
1221(a), it is a capital asset and eligible for the aforementioned
election.

Mechanics of election:Regs. Sec. 1.988-3(b)
addresses the requirements of making the Sec. 988(a)(1)(B)
capital gain/ loss election. The requirements for that election
are as follows:

The taxpayer makes the election by
clearly identifying the transaction in his or her books and
records on the date he or she enters into the transaction. While
no specific language or account is necessary for identifying a
transaction, the taxpayer must consistently apply the method of
identification and must clearly identify the particular
transaction subject to the election.

The taxpayer must
provide verification of the election by attaching a statement to
his or her income tax return that sets forth: (1) a description
and the date of each election made by the taxpayer during the
tax year; (2) a statement that each election made during the tax
year was made before the close of the date the transaction was
entered into; (3) a description of any contract for which an
election was in effect and the date such contract expired or was
otherwise sold or exchanged during the tax year; (4) a statement
that the contract was never part of a straddle as defined in
Sec. 1092; and (5) a statement that all transactions subject to
the election are included on the statement attached to the
taxpayer’s income tax return.

Observation:Taxpayers that do not comply
with these requirements run the risk of having the IRS
invalidate the election. However, if the failure was due to
reasonable cause or a bona fide mistake, taxpayers may be able
to obtain relief regarding that failure, but they have the
burden of proving that they are entitled to relief.
Fortunately, Regs. Sec. 1.988-3(b)(5) provides a way for most
taxpayers to obtain a presumption of having met the statement
and verification requirements by getting independent
verification. Taxpayers may get this verification by (1)
establishing a separate account (or accounts) with an
unrelated broker or dealer through which all transactions to
be independently verified are conducted and reported; (2)
having only those transactions entered into on or after the
date the taxpayer establishes the account be recorded in the
account; (3) having transactions subject to the election
entered into the account on the date the transactions are
entered into; and (4) obtaining from the broker or dealer a
statement detailing the transactions conducted through the
account that includes the following: “Each transaction
identified in this account is subject to the election set
forth in Sec. 988(a)(1)(B).”

In this example, it is
assumed that the investor fulfilled his or her obligations for
the election under Sec. 988(a)(1)(B), thereby resulting in the
treatment of the gain as capital in character.

Sec.
1256

Under Sec. 1256(a), certain contracts are generally
required to be marked to market if held by the taxpayer at the
close of the tax year and are further characterized as
generating gain or loss that is 40% short-term capital gain or
loss and 60% long-term capital gain or loss. Moreover, Sec.
1256(c) generally provides that Sec. 1256(a) applies even if
the contract is not held at year end (e.g., because of a
transfer, lapse, or other disposal during the year).

Sec. 1256(b), by its terms, covers the following types of
contracts (which are defined under Sec. 1256(g)): (1) any
regulated futures contract; (2) any foreign currency contract;
(3) any nonequity option; (4) any dealer equity option; and
(5) any dealer securities futures contract. Having addressed
regulated futures contracts and nonequity options above, and
noting that the option is not a dealer equity option or a
dealer securities futures contract (because K is not a
dealer), that leaves open the question of whether the option
is a foreign currency contract.

Under Sec.
1256(g)(2)(A), a foreign currency contract is defined as a
contract that:

Requires delivery of (or the
settlement of which depends on the value of) a foreign
currency that is a currency in which positions are also
traded through regulated futures contracts;

Is
traded in the interbank market; and

Is entered
into at arm’s length at a price determined by reference to
the price in the interbank market.

In a
nutshell, the option is not a foreign currency contract even
though a casual reading might suggest otherwise. The rationale
for this conclusion is as follows. In Notice 2007-71, the IRS
states that foreign currency options, regardless of whether
the underlying currency is one in which positions are traded
through regulated futures contracts, are not foreign currency
contracts as defined in Sec. 1256(g)(2). Apart from IRS
resistance to what they view as an abuse (not relevant to our
example), the notice explains that a

foreign
currency contract . . . [is] a contract that requires delivery
of, or the settlement of which depends on the value of,
certain foreign currencies. The original statutory definition,
however, did not allow for cash settlement and required actual
delivery of the underlying foreign currency in all
circumstances. Options, by their nature, only require delivery
if the option is exercised. Section 102 of the Tax Reform Act
of 1984 added the clause “or the settlement of which depends
on the value of.” There is no indication, however, that
Congress intended by this addition to extend the definition of
“foreign currency contract” to foreign currency options. That
conclusion is confirmed by the legislative history to
§988(c)(1)(E), enacted by the Technical and Miscellaneous
Revenue Act of 1988, which indicates that a foreign currency
option is not a foreign currency contract as defined in
§1256(g)(2). [Citations omitted.]

Moreover, Field
Service Advice (FSA) 200025020 (issued prior to Notice 2003- 81,
which was modified and supplemented by Notice 2007-71) provided
the following reasoning:

Although the definition of
a foreign currency contract provided in § 1256(g)(2) may be
read to include a foreign currency option contract, the
legislative history of the Technical Corrections Act of 1982,
which amended § 1256 to include foreign currency contracts,
indicates that the Congress intended to extend § 1256
treatment only to foreign currency forward contracts that are
traded on the interbank market. There is no indication that
foreign currency option contracts were contemplated for
inclusion in the statutory definition of a forward currency
contract in § 1256(g)(2)(A). Sections 1256(g)(3) and (4) deal
comprehensively with options listed on a qualified board or
exchange. These provisions were added to the Code by section
102(a)(3) of the Tax Reform Act of 1984. They provide that
only dealer equity options (i.e., listed stock options) and
listed options (other options listed on exchanges) are § 1256
contracts. The legislative history to these provisions is
silent regarding whether the failure to separately include a
provision addressing the treatment of foreign currency options
was due to their having been included within § 1256(g)(2)(A).
[Citations omitted.]

Further, commentators have
seemed to accept (or at least not dispute) that foreign currency
options are not foreign currency contracts. Consequently, the
option should not be treated as a foreign currency contract and
thus does not fall under Sec. 1256.

Holding Period

Having established that the option is a capital asset and
is not subject to Sec. 1256, the final step in the analysis is
determining whether the gain on its disposition is long term
or short term. Sec. 1222 generally controls the holding period
of property in determining the longterm versus short-term
character of the gain (or loss) on the disposition of a
capital asset. In short, that section provides that capital
gains are short term if held for not more than one year and
long term otherwise.

Without going into a great deal
on this issue (because it should be fairly apparent from the
trade and termination dates being less than 12 months), it is
clear that the gain is short term in nature.

Conclusion

As can be seen from the above, reaching
the ultimate answer to the initial query was not exactly a
straightforward proposition, highlighting the need for
additional clarity in similar situations. After all, even in
this relatively simple example the conclusion was dependent on
a close and critical reading of the legislative history, given
several easily misinterpreted terms in the statute itself.

EditorNotes

Mark Cook is a partner at
Singer Lewak LLP in Irvine, CA.

Unless otherwise noted, contributors are members of or
associated with Singer Lewak LLP.The editor would like to
offer a special thanks to Jennifer Allison, J.D., for her
assistance with this column.

For additional
information about these items, contact Mr. Cook at (949)
261-8600, ext. 2143, or mcook@singerlewak.com.

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